Are your savings going to sleep?

You don't have to resort to the mattress when interest rates are low. Melanie Bien reports on finding a better home for your cash

Saturday 13 October 2001 23:00 BST

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Falling interest rates are good news for borrowers but bad news for millions of savers. And with the Bank of England cutting rates six times this year – to a 40-year low – savers are running out of options.

To make matters worse, a number of banks don't bother informing customers that they have cut rates on savings accounts. But if you are relying on your savings for income, or simply want to maximise your returns, a rate cut is a big deal.

When it comes to saving, most of us want some emergency cash we can get our hands on quickly, as well as some money invested over the medium term – perhaps for a car, a holiday of a lifetime or school or university fees. And then we want money invested for the long term for our retirement.

Our rainy-day money should be kept in an instant access savings account paying the highest rate of interest we can find. Steer clear of the high street and opt for an internet savings account if you have access to the web. Intelligent Finance, for example, pays 5.01 per cent interest on balances of £1.

But you don't want too much money in a deposit account. "This shouldn't be a large capital sum; nobody should have £10,000 in an account no matter how risk-averse they are," says Donna Bradshaw, director at independent financial adviser (IFA) Fiona Price & Partners.

One alternative to the instant access savings account is a mini cash individual savings account. Most of these allow you to get your hands on your money without penalty when you need it. Returns are tax-free and you and your partner can each invest up to £3,000 each tax year. Smile pays 5.25 per cent on balances of £1, while Chelsea Building Society pays 5.65 per cent on balances of £10. This includes a 1 per cent bonus in the first year.

When times are hard there is often a flight to fixed-income investments such as bonds and gilts. These offer a guaranteed return on capital, a fixed income and a set maturity date. But the returns aren't as good as they have been because interest rates are low.

Investors who have a low-risk outlook should opt for a fixed-rate bond from a bank or building society. Julian Hodge Bank is paying 5.65 per cent on its five-year Capital Millennium Bond for those with a minimum investment of £1,000.

"Although rates [on fixed-income bonds] aren't as good as they have been, if interest rates are cut further, you know your income isn't going to be further affected," says Vivienne Starkey, partner at IFA Equal Partners. "It might be worth looking at fixed-income bonds over the short term, say a couple of years. Then you can move your money if the situation changes."

Another alternative is guaranteed income bonds. These are issued by life assurance companies rather than building societies and interest is paid net of basic-rate tax. They don't suit non-taxpayers because you can't claim the tax back. As with fixed-income bonds, they offer a fixed return over a set period.

Be wary of guaranteed equity bonds, which are linked to the stock market and might guarantee your income but not your capital. Look beyond the attractive headline rate and see what index it is tied to as some are riskier than others. A limited number of stocks will further increase the risk.

"You can get quite a good income from them but you have to think about your capital as well," says Ms Starkey. "They are not for everybody as they are very complicated. When markets are low it is time to look at these, but be extremely careful."

National Savings certificates also tend to be popular with savers but rates aren't very competitive at the moment and you can do better elsewhere. Corporate bonds are another option. These are issued by companies as a means of raising finance. They don't have the same degree of security as government bonds so they tend to pay more interest. The more risky a bond, the higher the rate of interest, so be careful if the rate looks too good to be true. High-yield, or "junk" bonds should be avoided unless you are happy to take on a high level of risk.

A corporate bond fund is a good way of reducing risk because you put money into a unit trust which invests in a wide spread of gilts and corporate bonds. Some funds are riskier than others; again, the higher the return, the more risk you are taking on.

"We are seeing quite a lot of interest in corporate bond funds," says Patrick Connolly, associate director at IFA Chartwell Investment Management. "But if the economy is struggling, the weakest companies will struggle, so look at the investment grade rather than higher-yield funds."

He recommends corporate bond funds from Norwich Union, Old Mutual and M&G.